Over the past 10 days, Wall Street chiefs have been queuing to announce that for them at least, the worst is over. They could well be right. But what about the rest of us?
The key text here – much quoted of late – is from John Maynard Keynes: “Whilst the weakening of credit is sufficient to bring about a collapse, its strengthening, though a necessary condition of recovery, is not a sufficient condition.” In other words, central banks can fix the credit system, but getting lending back to normal may be another matter.
Is the system really fixed? If so – and it feels like it – the turning point may have been not the Bear Stearns rescue, as often claimed, but the flood of liquidity from the central banks.
According to Tim Bond of Barclays Capital, in the months to the end of February assets held by US banks rose by $960bn. But deposits rose by only $293bn (£147.7bn), leaving a record gap of $667bn.
Normally, that would have been filled by the money market funds. They had liquidity to spare – in the same 12 months their cash inflow was $893bn.
But in a version of Northern Rock writ large, they no longer wanted to know. As recently as January 2006, all their monthly cash flow had gone into commercial and corporate paper. By February this year, that figure had shrunk to 11 per cent. Instead, the cash was going into safe havens such as Treasury bills.
This was all to do with the collapse of the shadow banking system – in particular, of off-balance sheet structures designed to hold mortgage-backed securities. As Mr Bond puts it, the banks had outsourced their assets and liabilities. The assets were now coming back on to their books, but the liabilities were not.
This is precisely the problem which the central bank rescues were designed to address. If the banks can swap those assets for Treasuries, then borrow against the Treasuries, they can plug the funding gap themselves.
Partly in consequence, equity funding becomes a lot easier, as shown by Royal Bank of Scotland’s £12bn ($24bn) rights issue last week. Deposits, too show signs of recovering. Much more of this, and the money markets will be open to the banks as usual.
If all this works, the crisis may turn out to have been fairly minor in historic terms. Citigroup calculates that even if all potential writedowns by US banks had to be bailed out by government, the fiscal hit would only amount to 8 per cent of gross domestic product. Compare that with 24 per cent in the case of Japan in 1991, or more than 50 per cent in the case of Argentina in 1980-82.
So is everything all right? Of course not. For a start, most central banks have been forced to take their eyes off the inflationary ball. As the credit crisis dies down, investors may move to worrying about inflation without missing a beat.
In which case, Treasuries are in for a tough time. For on top of the inflation premium, they will have to forego the extra buying by money market funds once more lured by the higher yield on commercial paper.
As for equities, there is the small matter of recession – triggered not just by the crisis, but by years of excessive leverage taken on by households and the financial sector. And as the Keynes quote reminds us, just because the banks are not going bust does not mean that they can lend as before – nor would they if they could.
There is also a quite separate issue of corporate profitability. Just as the banks have been on a supercycle for the past quarter of a century, so too have corporate profits as a proportion of gross domestic product. As luck would have it, both cycles look like peaking at the same time.
As JPMorgan baldly puts it, “the rise of the corporate profit share has come to an end”. The reasons had better be left to another column. The results, however, could prove material.
Even if the profit share held steady at its present rate, in a US context that would mean earnings rising only in line with nominal GDP – say, 4-5 per cent a year. Over the past 22 years, JPMorgan calculates, net US corporate earnings have increased by a compound average of 11 per cent. In fact, JPMorgan expects the profit share in the next four years to drop from 10.1 per cent to 8.8 per cent, leaving earnings more or less flat. And that, remember, is before taking recession into account.
One consequence will be a rise in corporate defaults. That will hit the banks, and so the next phase gets under way. The Wall Street chiefs may feel chirpier, but these are queasy times for everyone else.
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